Developing a sustainable tax strategy: the role of tax in the green transformation

Jan 17, 2023

Will Morris
Deputy Global Tax Policy Leader, PwC US
Niloufar Molavi
Global Oil & Gas Leader and US ESG Tax Leader, PwC US
Horacio Peña
US and Americas Transfer Pricing Leader, PwC US
Amparo Mercader
Tax Principal, Transfer Pricing, PwC US

This is part two of our US Inbound tax series on ESG and transparency. Part one can be found here.

Public and investor sentiment has intensified for companies to report on sustainability, including by the Securities and Exchange Commission (SEC), as part of the global shift toward so-called “stakeholder capitalism.” Corporations may decide to focus not just on shareholder value and meeting regulatory requirements, but also on demonstrating their broader contributions to society. This reflects a growing push from suppliers, employees, and even rating agencies and the public at large.  

ESG (Environmental, Social, and Governance) is the umbrella term for this development. While much of the emphasis is on the ‘E’ (e.g., net zero), the increased focus on tax as a measure of the social impact of companies, and how they are managed (“governed”), means that the ‘G’ and ‘S’ are being scrutinized more closely as well.  For example, some asset management firms and activist investors are among those urging public and portfolio companies to obtain and publish ESG scores prepared by credit agencies. 

Tax is a significant component of these ratings and can include elements like publicly released tax strategy, a stated commitment to compliance with tax laws and regulations, and the business’s global approach to transfer pricing, as well as whether there has been use of ‘tax havens.’ Thus, tax transparency is one of the most direct ways in which ESG is impacting tax departments (see prior blog, Greening the tax system: The role of tax in building a green economy, April 1, 2022).

While ESG initiatives have become important goals for many companies, there are differing views within business and investor communities as to whether, and to what extent, businesses should prioritize investing that may be considered socially responsible. Also the elements being measured under the heading ‘ESG’ beyond carbon emissions are broad, complex, and sometimes subjective. Corporations may be concerned that ESG ratings may create significant additional burdens and reputational risks without generating real societal change.

Back to the future

While the theme of transparency now falls under the umbrella of ESG, transparency has been a guiding force behind the Base Erosion and Profit Shifting (BEPS) initiative for over a decade (BEPS originated in the last global financial crisis). Tax departments of today’s multinational corporations have seen this evolution, starting with country-by-country reporting (CbCR) obligations driven by the Organisation of Economic Cooperation and Development (OECD). 

This trend continues. On November 11,  2021, the European Parliament adopted the Directive on public country-by-country reporting (PCbCR). The Directive aims to enhance the corporate transparency of large multinational companies. It will require certain multinational enterprises with revenue of more than EUR 750 million to disclose publicly in a specific report the income tax they pay broken out by country in the EU (and tax havens). This reporting obligation will impact European companies as well as foreign companies operating in Europe.

On November 28, 2022, the European Union (EU) formally adopted the Corporate Sustainability Reporting Directive (CSRD), which requires companies operating in the EU to publicly disclose and report on ESG issues. CSRD was published in the Official Journal of the European Union on December 16, and enters into force on January 5, 2023. EU member states then will have 18 months to incorporate it into their own national laws. CSRD amends a number of existing Directives and is a gamechanger for the world of business, not least because it applies to all large companies in Europe.

The first set of draft European Sustainability Reporting Standards, a significant part of the compliance and reporting framework, was submitted to the European Commission on November 23, 2022. Companies soon will face new, wider, and more complex sustainability reporting obligations. In this context, corporate legal teams need to understand the content and work with sustainability and corporate reporting teams in seeking to achieve compliant approaches and methodologies. Legal, commercial, and litigation risks also need to be considered should those methods be challenged.

Most recently, on December 13, 2022, after months of negotiations, the European Parliament and the EU Council reached an agreement on the Carbon Border Adjustment Mechanism (CBAM). As of October 1,  2023, EU-based businesses will need to report on carbon emission-intensive products imported from outside the EU. Beginning in 2026, these emissions also will need to be financially offset.

As background, the EU’s Green Deal, launched in 2019, aims to reduce carbon emissions by at least 55% by 2030. To achieve this, the number of freely allocated emission allowances in the EU’s Emission Trading System (ETS), a cap-and-trade system established in 2005, will be gradually phased out by 2034. In parallel, the CBAM will be phased in to ensure the international competitiveness of EU-based businesses compared to businesses that are based outside the EU and that may benefit from less stringent environmental regulations. Essentially, the CBAM aims to establish a competitive level playing field by compensating for the differences in carbon prices between domestic and imported products. (For further discussion, see PwC, EU deal reached on the CBAM: What you need to know, December 14, 2022.)

Meanwhile, in Australia, the Government’s proposed enhanced tax transparency measures, which were first announced as part of the Labor Government’s 2022 election commitment platform, are some of the most significant and wide-reaching tax integrity measures seen for many years. On August 5, 2022, the Federal Treasury released a Discussion Paper to consult by September 2, 2022, on the implementation of proposals intended to, among other things, ensure enhanced tax transparency by MNEs through measures such as public reporting of certain tax information on a country-by-country basis; mandatory reporting of material tax risks to shareholders; and requiring tenderers for Australian government contracts to disclose their country of tax “domicile.” There is still a long way to go before these measures are to be legislated but this is very definitely a sign of the times.. (For further discussion, see PwC Australia Tax Alert, Consultation on Government’s multinational tax proposals, August 8, 2022.)

Tax transparency standards

When it comes to tax and ESG, there are two key questions or areas that are ultimately being assessed, questions that may be difficult for taxpayers to answer or for the public at large to gauge:

  • Tax fairness: Are companies paying their “fair share” of taxes?
  • Tax transparency: Are companies being sufficiently transparent about taxes?

Regarding the fair share of taxes, this, of course, is a complex and, for some, a charged question. It is, by definition, a subjective test.  But it also can be viewed as a powerfully emotive term in the ‘S’ space; moreover, the pandemic, like other crises, has changed the narrative around tax fairness. Anticipated fiscal deficits could call for additional tax revenue, and multinational corporations once again may find themselves on the defensive, needing to provide a clear narrative around their societal contributions, including tax.  

In order to rank and rate companies in relation to the questions above, within this broader ESG framework of stakeholder capitalism the Global Reporting Initiative 207 (GRI 207) is a non-profit-driven initiative that sets forth reporting guidance that seeks to measure companies' sustainability performance. GRI 207 is a voluntary initiative that includes a number of metrics, including tax, to measure a company’s ESG status. The aim of GRI 207 is to show the contributions companies make to the countries in which they operate. These standards are intended to be taken into account by multinationals along with the rating agencies that have introduced ESG ratings and scorecards (discussed below).

Not only is there an expectation of additional reporting and public disclosure, but in the new world of digital transparency, a company’s public information is being digitally assessed and scored by third parties. Certain industries, like the asset management industry, increasingly are being assessed by ESG credit agencies.

Below we describe some of the tax metrics used by two ESG credit agencies that incorporate governance matters. Businesses should be aware of, and prepare for and react to, the use of these tax metrics.

S&P CapIQ leverages publicly available information in developing an ESG score. The key elements evaluated include:

  • Tax policy or tax strategy: Tax strategy and governance includes publicly available and group-wide tax policy, strategy, or principles that are in place to indicate the organization’s approach to taxation.
  • Reporting: Tax reporting includes publicly available reports on key business, financial, and tax information for each tax jurisdiction where entities are residents for tax purposes and reported as such in the organization’s consolidated financial statements.
  • Effective tax rate (ETR): Quantitative inputs such as effective tax rate and cash tax rate, as well as explanations as to why these tax rates may be lower than industry averages. 

MSCI Tax Transparency is another rating agency that evaluates companies on their estimated corporate tax gap (i.e., the difference between estimated ETR and estimated statutory tax rate) and their involvement in tax-related controversies. Metrics include:

  • ETR using the actual tax paid and the company’s income before tax
  • Disclosure and tax transparency
  • Track record of ‘controversial’ tax practices.

These reporting agencies and scorecards are in addition to the SEC proposed disclosure requirements for ESG matters recently released for public consultation. The proposed SEC disclosures do not currently include tax-specific matters, and focus only on carbon emissions and environmental matters.  (For prior coverage, see PwC Insight, SEC climate disclosures and your company.)

Key takeaways

Tax is an increasingly important component of ESG and a specific metric of ESG scores. Rating agencies compare companies to their peers on issues like accounting ratios, tax controversy, and ETR. For this purpose, rating agencies analyze existing publicly disclosed information as they typically gather data from natural-language AI software. Understanding the inputs and developing their narrative around their specific circumstances can help a company seeking a positive ESG score.

In response to this trend toward tax transparency, some companies are proactively exploring tax disclosure and communication in a way intended to articulate their own circumstances. Tax departments can take steps to disclose the economic impact of a company's total tax contribution (TTC), which is a measure of all economic contributions made to society. Companies are using this data for internal communication purposes, better management, external communication, and overall communication strategy around tax and their contributions to society. (For deeper discussion of TTC, see PwC, The Total Tax Contribution Framework: Tax takes a step towards sustainability.)

Next steps

Companies should discuss with their advisors the Tax department’s role in ESG scoring and any potential issues that could arise from public disclosures. Areas that might be perceived as negative when a company’s tax profile becomes public could be better addressed and managed through comprehensive narrative, as well as, for example, through Advance Pricing Agreements (APAs). Benchmark studies that evaluate a company’s tax profile relative to its peers can help frame the sustainability narrative in response to the ESG expectations and help articulate the multinational companies’ total contributions in a way that may facilitate ESG scoring and help manage reputational risks.

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